1. The Basic Exchange Contracts

There is a general consensus among Islamic jurists on the view that currencies
of different countries can be exchanged on a spot basis at a rate different
from unity, since currencies of different countries are distinct entities
with different values or intrinsic worth, and purchasing power. There also
seems to be a general agreement among a majority of scholars on the view
that currency exchange on a forward basis is not permissible, that is,
when the rights and obligations of both parties relate to a future date.
However, there is considerable difference of opinion among jurists when
the rights of either one of the parties, which is same as obligation of
the counterparty, is deferred to a future date.

To elaborate, let us consider the example of two individuals A and B
who belong to two different countries, India and US respectively. A intends
to sell Indian rupees and buy U.S dollars. The converse is true for B.
The rupee-dollar exchange rate agreed upon is 1:20 and the transaction
involves buying and selling of $50. The first situation is that A makes
a spot payment of Rs1000 to B and accepts payment of $50 from B. The transaction
is settled on a spot basis from both ends. Such transactions are valid
and Islamically permissible. There are no two opinions about the same.
The second possibility is that settlement of the transaction from both
ends is deferred to a future date, say after six months from now. This
implies that both A and B would make and accept payment of Rs1000 or $50,
as the case may be, after six months. The predominant view is that such
a contract is not Islamically permissible. A minority view considers it
permissible. The third scenario is that the transaction is partly settled
from one end only. For example, A makes a payment of Rs1000 now to B in
lieu of a promise by B to pay $50 to him after six months. Alternatively,
A accepts $50 now from B and promises to pay Rs1000 to him after six months.
There are diametrically opposite views on the permissibility of such contracts
which amount to bai-salam in currencies. The purpose of this paper is to
present a comprehensive analysis of various arguments in support and against
the permissibility of these basic contracts involving currencies. The first
form of contracting involving exchange of countervalues on a spot basis
is beyond any kind of controversy. Permissibility or otherwise of the second
type of contract in which delivery of one of the countervalues is deferred
to a future date, is generally discussed in the framework of riba prohibition.
Accordingly we discuss this contract in detail in section 2 dealing with
the issue of prohibition of riba. Permissibility of the third form of contract
in which delivery of both the countervalues is deferred, is generally discussed
within the framework of reducing risk and uncertainty or gharar involved
in such contracts. This, therefore, is the central theme of section 3 which
deals with the issue of gharar. Section 4 attempts a holistic view of the
Sharia relates issues as also the economic significance of the basic forms
of contracting in the currency market.

2. The Issue of Riba Prohibition

The divergence of views1 on the permissibility or otherwise of exchange
contracts in currencies can be traced primarily to the issue of riba prohibition.

The need to eliminate riba in all forms of exchange contracts is of
utmost importance. Riba in its Sharia context is generally defined2 as
an unlawful gain derived from the quantitative inequality of the countervalues
in any transaction purporting to effect the exchange of two or more species
(anwa), which belong to the same genus (jins) and are governed by the same
efficient cause (illa). Riba is generally classified into riba al-fadl
(excess) and riba al-nasia (deferment) which denote an unlawful advantage
by way of excess or deferment respectively. Prohibition of the former is
achieved by a stipulation that the rate of exchange between the objects
is unity and no gain is permissible to either party. The latter kind of
riba is prohibited by disallowing deferred settlement and ensuring that
the transaction is settled on the spot by both the parties. Another form
of riba is called riba al-jahiliyya or pre-Islamic riba which surfaces
when the lender asks the borrower on the maturity date if the latter would
settle the debt or increase the same. Increase is accompanied by charging
interest on the amount initially borrowed.

The prohibition of riba in the exchange of currencies belonging to different
countries requires a process of analogy (qiyas). And in any such exercise
involving analogy (qiyas), efficient cause (illa) plays an extremely important
role. It is a common efficient cause (illa), which connects the object
of the analogy with its subject, in the exercise of analogical reasoning.
The appropriate efficient cause (illa) in case of exchange contracts has
been variously defined by the major schools of Fiqh. This difference is
reflected in the analogous reasoning for paper currencies belonging to
different countries.

A question of considerable significance in the process of analogous
reasoning relates to the comparison between paper currencies with gold
and silver. In the early days of Islam, gold and silver performed all the
functions of money (thaman). Currencies were made of gold and silver with
a known intrinsic value (quantum of gold or silver contained in them).
Such currencies are described as thaman haqiqi, or naqdain in Fiqh literature.
These were universally acceptable as principal means of exchange, accounting
for a large chunk of transactions. Many other commodities, such as, various
inferior metals also served as means of exchange, but with limited acceptability.
These are described as fals in Fiqh literature. These are also known as
thaman istalahi because of the fact that their acceptability stems not
from their intrinsic worth, but due to the status accorded by the society
during a particular period of time. The above two forms of currencies have
been treated very differently by early Islamic jurists from the standpoint
of permissibility of contracts involving them. The issue that needs to
be resolved is whether the present age paper currencies fall under the
former category or the latter. One view is that these should be treated
at par with thaman haqiqi or gold and silver, since these serve as the
principal means of exchange and unit of account like the latter. Hence,
by analogous reasoning, all the Sharia-related norms and injunctions applicable
to thaman haqiqi should also be applicable to paper currency. Exchange
of thaman haqiqi is known as bai-sarf, and hence, the transactions in paper
currencies should be governed by the Sharia rules relevant for bai-sarf.
The contrary view asserts that paper currencies should be treated in a
manner similar to fals or thaman istalahi because of the fact that their
face value is different from their intrinsic worth. Their acceptability
stems from their legal status within the domestic country or global economic
importance (as in case of US dollars, for instance).

2.1. A Synthesis of Alternative Views

2.1.1. Analogical Reasoning (Qiyas) for Riba Prohibition

The prohibition of riba is based on the tradition that the holy prophet
(peace be upon him) said, "Sell gold for gold, silver for silver, wheat
for wheat, barley for barley, date for date, salt for salt, in same quantities
on the spot; and when the commodities are different, sell as it suits you,
but on the spot." Thus, the prohibition of riba applies primarily to the
two precious metals (gold and silver) and four other commodities (wheat,
barley, dates and salt). It also applies, by analogy (qiyas) to all species
which are governed by the same efficient cause (illa) or which belong to
any one of the genera of the six objects cited in the tradition. However,
there is no general agreement among the various schools of Fiqh and even
scholars belonging to the same school on the definition and identification
of efficient cause (illa) of riba.

For the Hanafis, efficient cause (illa) of riba has two dimensions:
the exchanged articles belong to the same genus (jins); these possess weight
(wazan) or measurability (kiliyya). If in a given exchange, both the elements
of efficient cause (illa) are present, that is, the exchanged countervalues
belong to the same genus (jins) and are all weighable or all measurable,
then no gain is permissible (the exchange rate must be equal to unity)
and the exchange must be on a spot basis. In case of gold and silver, the
two elements of efficient cause (illa) are: unity of genus (jins) and weighability.
This is also the Hanbali view according to one version3. (A different version
is similar to the Shafii and Maliki view, as discussed below.) Thus, when
gold is exchanged for gold, or silver is exchanged for silver, only spot
transactions without any gain are permissible. It is also possible that
in a given exchange, one of the two elements of efficient cause (illa)
is present and the other is absent. For example, if the exchanged articles
are all weighable or measurable but belong to different genus (jins) or,
if the exchanged articles belong to same genus (jins) but neither is weighable
nor measurable, then exchange with gain (at a rate different from unity)
is permissible, but the exchange must be on a spot basis. Thus, when gold
is exchanged for silver, the rate can be different from unity but no deferred
settlement is permissible. If none of the two elements of efficient cause
(illa) of riba are present in a given exchange, then none of the injunctions
for riba prohibition apply. Exchange can take place with or without gain
and both on a spot or deferred basis.

Considering the case of exchange involving paper currencies belonging
to different countries, riba prohibition would require a search for efficient
cause (illa). Currencies belonging to different countries are clearly distinct
entities; these are legal tender within specific geographical boundaries
with different intrinsic worth or purchasing power. Hence, a large majority
of scholars perhaps rightly assert that there is no unity of genus (jins).
Additionally, these are neither weighable nor measurable. This leads to
a direct conclusion that none of the two elements of efficient cause (illa)
of riba exist in such exchange. Hence, the exchange can take place free
from any injunction regarding the rate of exchange and the manner of settlement.
The logic underlying this position is not difficult to comprehend. The
intrinsic worth of paper currencies belonging to different countries differ
as these have different purchasing power. Additionally, the intrinsic value
or worth of paper currencies cannot be identified or assessed unlike gold
and silver which can be weighed. Hence, neither the presence of riba al-fadl
(by excess), nor riba al-nasia (by deferment) can be established.

The Shafii school of Fiqh considers the efficient cause (illa) in case
of gold and silver to be their property of being currency (thamaniyya)
or the medium of exchange, unit of account and store of value . This is
also the Maliki view. According to one version of this view, even if paper
or leather is made the medium of exchange and is given the status of currency,
then all the rules pertaining to naqdain, or gold and silver apply to them.
Thus, according to this version, exchange involving currencies of different
countries at a rate different from unity is permissible, but must be settled
on a spot basis. Another version of the above two schools of thought is
that the above cited efficient cause (illa) of being currency (thamaniyya)
is specific to gold and silver, and cannot be generalized. That is, any
other object, if used as a medium of exchange, cannot be included in their
category. Hence, according to this version, the Sharia injunctions for
riba prohibition are not applicable to paper currencies. Currencies belonging
to different countries can be exchanged with or without gain and both on
a spot or deferred basis.

Proponents of the earlier version cite the case of exchange of paper
currencies belonging to the same country in defense of their version. The
consensus opinion of jurists in this case is that such exchange must be
without any gain or at a rate equal to unity and must be settled on a spot
basis. What is the rationale underlying the above decision? If one considers
the Hanafi and the first version of Hanbali position then, in this case,
only one dimension of the efficient cause (illa) is present, that is, they
belong to the same genus (jins). But paper currencies are neither weighable
nor measurable. Hence, Hanafi law would apparently permit exchange of different
quantities of the same currency on a spot basis. Similarly if the efficient
cause of being currency (thamaniyya) is specific only to gold and silver,
then Shafii and Maliki law would also permit the same. Needless to say,
this amounts to permitting riba-based borrowing and lending. This shows
that, it is the first version of the Shafii and Maliki thought which underlies
the consensus decision of prohibition of gain and deferred settlement in
case of exchange of currencies belonging to the same country. According
to the proponents, extending this logic to exchange of currencies of different
countries would imply that exchange with gain or at a rate different from
unity is permissible (since there no unity of jins), but settlement must
be on a spot basis.

2.1.2 Comparison between Currency Exchange and Bai-Sarf

Bai-sarf is defined in Fiqh literature as an exchange involving thaman
haqiqi, defined as gold and silver, which served as the principal medium
of exchange for almost all major transactions.

Proponents of the view that any exchange of currencies of different
countries is same as bai-sarf argue that in the present age paper currencies
have effectively and completely replaced gold and silver as the medium
of exchange. Hence, by analogy, exchange involving such currencies should
be governed by the same Sharia rules and injunctions as bai-sarf. It is
also argued that if deferred settlement by either parties to the contract
is permitted, this would open the possibilities of riba-al nasia.

Opponents of categorization of currency exchange with bai-sarf however
point out that the exchange of all forms of currency (thaman) cannot be
termed as bai-sarf. According to this view bai-sarf implies exchange of
currencies made of gold and silver (thaman haqiqi or naqdain) alone and
not of money pronounced as such by the state authorities (thaman istalahi).
The present age currencies are examples of the latter kind. These scholars
find support in those writings which assert that if the commodities of
exchange are not gold or silver, (even if one of these is gold or silver)
then, the exchange cannot be termed as bai-sarf. Nor would the stipulations
regarding bai-sarf be applicable to such exchanges. According to Imam Sarakhsi4
"when an individual purchases fals or coins made out of inferior metals,
such as, copper (thaman istalahi) for dirhams (thaman haqiqi) and makes
a spot payment of the latter, but the seller does not have fals at that
moment, then such exchange is permissible........ taking possession of
commodities exchanged by both parties is not a precondition" (while in
case of bai-sarf, it is.) A number of similar references exist which indicate
that jurists do not classify an exchange of fals (thaman istalahi) for
another fals (thaman istalahi) or gold or silver (thaman haqiqi), as bai-sarf.

Hence, the exchanges of currencies of two different countries which
can only qualify as thaman istalahi can not be categorized as bai-sarf.
Nor can the constraint regarding spot settlement be imposed on such transactions.
It should be noted here that the definition of bai-sarf is provided Fiqh
literature and there is no mention of the same in the holy traditions.
The traditions mention about riba, and the sale and purchase of gold and
silver (naqdain) which may be a major source of riba, is described as bai-sarf
by the Islamic jurists. It should also be noted that in Fiqh literature,
bai-sarf implies exchange of gold or silver only; whether these are currently
being used as medium of exchange or not. Exchange involving dinars and
gold ornaments, both quality as bai-sarf. Various jurists have sought to
clarify this point and have defined sarf as that exchange in which both
the commodities exchanged are in the nature of thaman, not necessarily
thaman themselves. Hence, even when one of the commodities is processed
gold (say, ornaments), such exchange is called bai-sarf.

Proponents of the view that currency exchange should be treated in a
manner similar to bai-sarf also derive support from writings of eminent
Islamic jurists. According to Imam Ibn Taimiya "anything that performs
the functions of medium of exchange, unit of account, and store of value
is called thaman, (not necessarily limited to gold & silver). Similar
references are available in the writings of Imam Ghazzali5 As far as the
views of Imam Sarakhshi is concerned regarding exchange involving fals,
according to them, some additional points need to be taken note of. In
the early days of Islam, dinars and dirhams made of gold and silver were
mostly used as medium of exchange in all major transactions. Only the minor
ones were settled with fals. In other words, fals did not possess the characteristics
of money or thamaniyya in full and was hardly used as store of value or
unit of account and was more in the nature of commodity. Hence there was
no restriction on purchase of the same for gold and silver on a deferred
basis. The present day currencies have all the features of thaman and are
meant to be thaman only. The exchange involving currencies of different
countries is same as bai-sarf with difference of jins and hence, deferred
settlement would lead to riba al-nasia.

Dr Mohamed Nejatullah Siddiqui illustrates this possibility with an
example6. He writes "In a given moment in time when the market rate of
exchange between dollar and rupee is 1:20, if an individual purchases $50
at the rate of 1:22 (settlement of his obligation in rupees deferred to
a future date), then it is highly probable that he is , in fact, borrowing
Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later
date. (Since, he can obtain Rs 1000 now, exchanging the $50 purchased on
credit at spot rate)" Thus, sarf can be converted into interest-based borrowing
& lending.

2.1.3 Defining Thamaniyya is the Key ?

It appears from the above synthesis of alternative views that the key
issue seems to be a correct definition of thamaniyya. For instance, a fundamental
question that leads to divergent positions on permissibility relates to
whether thamaniyya is specific to gold and silver, or can be associated
with anything that performs the functions of money. We raise some issues
below which may be taken into account in any exercise in reconsideration
of alternative positions.

It should be appreciated that thamaniyya may not be absolute and may
vary in degrees. It is true that paper currencies have completely replaced
gold and silver as medium of exchange, unit of account and store of value.
In this sense, paper currencies can be said to possess thamaniyya. However,
this is true for domestic currencies only and may not be true for foreign
currencies. In other words, Indian rupees possess thamaniyya within the
geographical boundaries of India only, and do not have any acceptability
in US. These cannot be said to possess thamaniyya in US unless a US citizen
can use Indian rupees as a medium of exchange, or unit of account, or store
of value. In most cases such a possibility is remote. This possibility
is also a function of the exchange rate mechanism in place, such as, convertibility
of Indian rupees into US dollars, and whether a fixed or floating exchange
rate system is in place. For example, assuming free convertibility of Indian
rupees into US dollars and vice versa, and a fixed exchange rate system
in which the rupee-dollar exchange rate is not expected to increase or
decrease in the foreseeable future, thamaniyya of rupee in US is considerably
improved. The example cited by Dr Nejatullah Siddiqui also appears quite
robust under the circumstances. Permission to exchange rupees for dollars
on a deferred basis (from one end, of course) at a rate different from
the spot rate (official rate which is likely to remain fixed till the date
of settlement) would be a clear case of interest-based borrowing and lending.
However, if the assumption of fixed exchange rate is relaxed and the present
system of fluctuating and volatile exchange rates is assumed to be the
case, then it can be shown that the case of riba al-nasia breaks down.
We rewrite his example: "In a given moment in time when the market rate
of exchange between dollar and rupee is 1:20, if an individual purchases
$50 at the rate of 1:22 (settlement of his obligation in rupees deferred
to a future date), then it is highly probable that he is , in fact, borrowing
Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later
date. (Since, he can obtain Rs 1000 now, exchanging the $50 purchased on
credit at spot rate)" This would be so, only if the currency risk is non-existent
(exchange rate remains at 1:20), or is borne by the seller of dollars (buyer
repays in rupees and not in dollars). If the former is true, then the seller
of the dollars (lender) receives a predetermined return of ten percent
when he converts Rs1100 received on the maturity date into $55 (at an exchange
rate of 1:20). However, if the latter is true, then the return to the seller
(or the lender) is not predetermined. It need not even be positive. For
example, if the rupee-dollar exchange rate increases to 1:25, then the
seller of dollar would receive only $44 (Rs 1100 converted into dollars)
for his investment of $50.

Here two points are worth noting. First, when one assumes a fixed exchange
rate regime, the distinction between currencies of different countries
gets diluted. The situation becomes similar to exchanging pounds with sterlings
(currencies belonging to the same country) at a fixed rate. Second, when
one assumes a volatile exchange rate system, then just as one can visualize
lending through the foreign currency market (mechanism suggested in the
above example), one can also visualize lending through any other organized
market (such as, for commodities or stocks.) If one replaces dollars for
stocks in the above example, it would read as: "In a given moment in time
when the market price of stock X is Rs 20, if an individual purchases 50
stocks at the rate of Rs 22 (settlement of his obligation in rupees deferred
to a future date), then it is highly probable that he is , in fact, borrowing
Rs. 1000 now in lieu of a promise to repay Rs. 1100 on a specified later
date. (Since, he can obtain Rs 1000 now, exchanging the 50 stocks purchased
on credit at current price)" In this case too as in the earlier example,
returns to the seller of stocks may be negative if stock price rises to
Rs 25 on the settlement date. Hence, just as returns in the stock market
or commodity market are Islamically acceptable because of the price risk,
so are returns in the currency market because of fluctuations in the prices
of currencies.

A unique feature of thaman haqiqi or gold and silver is that the intrinsic
worth of the currency is equal to its face value. Thus, the question of
different geographical boundaries within which a given currency, such as,
dinar or dirham circulates, is completely irrelevant. Gold is gold whether
in country A or country B. Thus, when currency of country A made of gold
is exchanged for currency of country B, also made of gold, then any deviation
of the exchange rate from unity or deferment of settlement by either party
cannot be permitted as it would clearly involve riba al-fadl and also riba
al-nasia. However, when paper currencies of country A is exchanged for
paper currency of country B, the case may be entirely different. The price
risk (exchange rate risk), if positive, would eliminate any possibility
of riba al-nasia in the exchange with deferred settlement. However, if
price risk (exchange rate risk) is zero, then such exchange could be a
source of riba al-nasia if deferred settlement is permitted7.

Another point that merits serious consideration is the possibility that
certain currencies may possess thamaniyya, that is, used as a medium of
exchange, unit of account, or store of value globally, within the domestic
as well as foreign countries. For instance, US dollar is legal tender within
US; it is also acceptable as a medium of exchange or unit of account for
a large volume of transactions across the globe. Thus, this specific currency
may be said to possesses thamaniyya globally, in which case, jurists may
impose the relevant injunctions on exchanges involving this specific currency
to prevent riba al-nasia. The fact is that when a currency possesses thamaniyya
globally, then economic units using this global currency as the medium
of exchange, unit of account or store of value may not be concerned about
risk arising from volatility of inter-country exchange rates. At the same
time, it should be recognized that a large majority of currencies do not
perform the functions of money except within their national boundaries
where these are legal tender.

Riba and risk cannot coexist in the same contract. The former connotes
a possibility of returns with zero risk and cannot be earned through a
market with positive price risk. As has been discussed above, the possibility
of riba al-fadl or riba al-nasia may arise in exchange when gold or silver
function as thaman; or when the exchange involves paper currencies belonging
to the same country; or when the exchange involves currencies of different
countries following a fixed exchange rate system. The last possibility
is perhaps unIslamic8 since price or exchange rate of currencies should
be allowed to fluctuate freely in line with changes in demand and supply
and also because prices should reflect the intrinsic worth or purchasing
power of currencies. The foreign currency markets of today are characterised
by volatile exchange rates. The gains or losses made on any transaction
in currencies of different countries, are justified by the risk borne by
the parties to the contract.

2.1.4. Possibility of Riba with Futures and Forwards

So far, we have discussed views on the permissibility of bai salam in
currencies, that is, when the obligation of only one of the parties to
the exchange is deferred. What are the views of scholars on deferment of
obligations of both parties ? Typical example of such contracts are forwards
and futures9. According to a large majority of scholars, this is not permissible
on various grounds, the most important being the element of risk and uncertainty
(gharar) and the possibility of speculation of a kind which is not permissible.
This is discussed in section 3. However, another ground for rejecting such
contracts may be riba prohibition. In the preceding paragraph we have discussed
that bai salam in currencies with fluctuating exchange rates can not be
used to earn riba because of the presence of currency risk. It is possible
to demonstrate that currency risk can be hedged or reduced to zero with
another forward contract transacted simultaneously. And once risk is eliminated,
the gain clearly would be riba.

We modify and rewrite the same example: "In a given moment in time when
the market rate of exchange between dollar and rupee is 1:20, an individual
purchases $50 at the rate of 1:22 (settlement of his obligation in rupees
deferred to a future date), and the seller of dollars also hedges his position
by entering into a forward contract to sell Rs1100 to be received on the
future date at a rate of 1:20, then it is highly probable that he is ,
in fact, borrowing Rs. 1000 now in lieu of a promise to repay Rs. 1100
on a specified later date. (Since, he can obtain Rs 1000 now, exchanging
the 50 dollars purchased on credit at spot rate)" The seller of the dollars
(lender) receives a predetermined return of ten percent when he converts
Rs1100 received on the maturity date into 55 dollars (at an exchange rate
of 1:20) for his investment of 50 dollars irrespective of the market rate
of exchange prevailing on the date of maturity.

Another simple possible way to earn riba may even involve a spot transaction
and a simultaneous forward transaction. For example, the individual in
the above example purchases $50 on a spot basis at the rate of 1:20 and
simultaneously enters into a forward contract with the same party to sell
$50 at the rate of 1:21 after one month. In effect this implies that he
is lending Rs1000 now to the seller of dollars for one month and earns
an interest of Rs50 (he receives Rs1050 after one month. This is a typical
buy-back or repo (repurchase) transaction so common in conventional banking.10

3. The Issue of Freedom from Gharar

3.1 Defining Gharar

Gharar, unlike riba, does not have a consensus definition. In broad
terms, it connotes risk and uncertainty. It is useful to view gharar as
a continuum of risk and uncertainty wherein the extreme point of zero risk
is the only point that is well-defined. Beyond this point, gharar becomes
a variable and the gharar involved in a real life contract would lie somewhere
on this continuum. Beyond a point on this continuum, risk and uncertainty
or gharar becomes unacceptable11. Jurists have attempted to identify such
situations involving forbidden gharar. A major factor that contributes
to gharar is inadequate information (jahl) which increases uncertainty.
This is when the terms of exchange, such as, price, objects of exchange,
time of settlement etc. are not well-defined. Gharar is also defined in
terms of settlement risk or the uncertainty surrounding delivery of the
exchanged articles.

Islamic scholars have identified the conditions which make a contract
uncertain to the extent that it is forbidden. Each party to the contract
must be clear as to the quantity, specification, price, time, and place
of delivery of the contract. A contract, say, to sell fish in the river
involves uncertainty about the subject of exchange, about its delivery,
and hence, not Islamically permissible. The need to eliminate any element
of uncertainty inherent in a contract is underscored by a number of traditions.12

An outcome of excessive gharar or uncertainty is that it leads to the
possibility of speculation of a variety which is forbidden. Speculation
in its worst form, is gambling. The holy Quran and the traditions of the
holy prophet explicitly prohibit gains made from games of chance which
involve unearned income. The term used for gambling is maisir which literally
means getting something too easily, getting a profit without working for
it. Apart from pure games of chance, the holy prophet also forbade actions
which generated unearned incomes without much productive efforts.13

Here it may be noted that the term speculation has different connotations.
It always involves an attempt to predict the future outcome of an event.
But the process may or may not be backed by collection, analysis and interpretation
of relevant information. The former case is very much in conformity with
Islamic rationality. An Islamic economic unit is required to assume risk
after making a proper assessment of risk with the help of information.
All business decisions involve speculation in this sense. It is only in
the absence of information or under conditions of excessive gharar or uncertainty
that speculation is akin to a game of chance and is reprehensible.

3.2 Gharar & Speculation with of Futures & Forwards

Considering the case of the basic exchange contracts highlighted in
section 1, it may be noted that the third type of contract where settlement
by both the parties is deferred to a future date is forbidden, according
to a large majority of jurists on grounds of excessive gharar. Futures
and forwards in currencies are examples of such contracts under which two
parties become obliged to exchange currencies of two different countries
at a known rate at the end of a known time period. For example, individuals
A and B commit to exchange US dollars and Indian rupees at the rate of
1: 22 after one month. If the amount involved is $50 and A is the buyer
of dollars then, the obligations of A and B are to make a payments of Rs1100
and $50 respectively at the end of one month. The contract is settled when
both the parties honour their obligations on the future date.

Traditionally, an overwhelming majority of Sharia scholars have disapproved
such contracts on several grounds. The prohibition applies to all such
contracts where the obligations of both parties are deferred to a future
date, including contracts involving exchange of currencies. An important
objection is that such a contract involves sale of a non-existent object
or of an object not in the possession of the seller. This objection is
based on several traditions of the holy prophet.14 There is difference
of opinion on whether the prohibition in the said traditions apply to foodstuffs,
or perishable commodities or to all objects of sale. There is, however,
a general agreement on the view that the efficient cause (illa) of the
prohibition of sale of an object which the seller does not own or of sale
prior to taking possession is gharar, or the possible failure to deliver
the goods purchased.

Is this efficient cause (illa) present in an exchange involving future
contracts in currencies of different countries ? In a market with full
and free convertibility or no constraints on the supply of currencies,
the probability of failure to deliver the same on the maturity date should
be no cause for concern. Further, the standardized nature of futures contracts
and transparent operating procedures on the organized futures markets15
is believed to minimize this probability. Some recent scholars have opined
in the light of the above that futures, in general, should be permissible.
According to them, the efficient cause (illa), that is, the probability
of failure to deliver was quite relevant in a simple, primitive and unorganized
market. It is no longer relevant in the organized futures markets of today16.
Such contention, however, continues to be rejected by the majority of scholars.
They underscore the fact that futures contracts almost never involve delivery
by both parties. On the contrary, parties to the contract reverse the transaction
and the contract is settled in price difference only. For example, in the
above example, if the currency exchange rate changes to 1: 23 on the maturity
date, the reverse transaction for individual A would mean selling $50 at
the rate of 1:23 to individual B. This would imply A making a gain of Rs50
(the difference between Rs1150 and Rs1100). This is exactly what B would
lose. It may so happen that the exchange rate would change to 1:21 in which
case A would lose Rs50 which is what B would gain. This obviously is a
zero-sum game in which the gain of one party is exactly equal to the loss
of the other. This possibility of gains or losses (which theoretically
can touch infinity) encourages economic units to speculate on the future
direction of exchange rates. Since exchange rates fluctuate randomly, gains
and losses are random too and the game is reduced to a game of chance.
There is a vast body of literature on the forecastability of exchange rates
and a large majority of empirical studies have provided supporting evidence
on the futility of any attempt to make short-run predictions. Exchange
rates are volatile and remain unpredictable at least for the large majority
of market participants. Needless to say, any attempt to speculate in the
hope of the theoretically infinite gains is, in all likelihood, a game
of chance for such participants. While the gains, if they materialize,
are in the nature of maisir or unearned gains, the possibility of equally
massive losses do indicate a possibility of default by the loser and hence,
gharar.

3.3. Risk Management in Volatile Markets

Hedging or risk reduction adds to planning and managerial efficiency.
The economic justification of futures and forwards is in term of their
role as a device for hedging. In the context of currency markets which
are characterized by volatile rates, such contracts are believed to enable
the parties to transfer and eliminate risk arising out of such fluctuations.
For example, modifying the earlier example, assume that individual A is
an exporter from India to US who has already sold some commodities to B,
the US importer and anticipates a cashflow of $50 (which at the current
market rate of 1:22 mean Rs 1100 to him) after one month. There is a possibility
that US dollar may depreciate against Indian rupee during these one month,
in which case A would realize less amount of rupees for his $50 ( if the
new rate is 1:21, A would realize only Rs1050 ). Hence, A may enter into
a forward or future contract to sell $50 at the rate of 1:21.5 at the end
of one month (and thereby, realize Rs1075) with any counterparty which,
in all probability, would have diametrically opposite expectations regarding
future direction of exchange rates. In this case, A is able to hedge his
position and at the same time, forgoes the opportunity of making a gain
if his expectations do not materialize and US dollar appreciates against
Indian rupee (say, to 1:23 which implies that he would have realized Rs1150,
and not Rs1075 which he would realize now.) While hedging tools always
improve planning and hence, performance, it should be noted that the intention
of the contracting party - whether to hedge or to speculate, can never
be ascertained.

It may be noted that hedging can also be accomplished with bai salam
in currencies. As in the above example, exporter A anticipating a cash
inflow of $50 after one month and expecting a depreciation of dollar may
go for a salam sale of $50 (with his obligation to pay $50 deferred by
one month.) Since he is expecting a dollar depreciation, he may agree to
sell $50 at the rate of 1: 21.5. There would be an immediate cash inflow
in Rs 1075 for him. The question may be, why should the counterparty pay
him rupees now in lieu of a promise to be repaid in dollars after one month.
As in the case of futures, the counterparty would do so for profit, if
its expectations are diametrically opposite, that is, it expects dollar
to appreciate. For example, if dollar appreciates to 1: 23 during the one
month period, then it would receive Rs1150 for Rs 1075 it invested in the
purchase of $50. Thus, while A is able to hedge its position, the counterparty
is able to earn a profit on trading of currencies. The difference from
the earlier scenario is that the counterparty would be more restrained
in trading because of the investment required, and such trading is unlikely
to take the shape of rampant speculation.

4. Summary & Conclusion

Currency markets of today are characterized by volatile exchange rates.
This fact should be taken note of in any analysis of the three basic types
of contracts in which the basis of distinction is the possibility of deferment
of obligations to future. We have attempted an assessment of these forms
of contracting in terms of the overwhelming need to eliminate any possibility
of riba, minimize gharar, jahl and the possibility of speculation of a
kind akin to games of chance. In a volatile market, the participants are
exposed to currency risk and Islamic rationality requires that such risk
should be minimized in the interest of efficiency if not reduced to zero.

It is obvious that spot settlement of the obligations of both parties
would completely prohibit riba, and gharar, and minimize the possibility
of speculation. However, this would also imply the absence of any technique
of risk management and may involve some practical problems for the participants.

At the other extreme, if the obligations of both the parties are deferred
to a future date, then such contracting, in all likelihood, would open
up the possibility of infinite unearned gains and losses from what may
be rightly termed for the majority of participants as games of chance.
Of course, these would also enable the participants to manage risk through
complete risk transfer to others and reduce risk to zero. It is this possibility
of risk reduction to zero which may enable a participant to earn riba.
Future is not a new form of contract. Rather the justification for proscribing
it is new. If in a simple primitive economy, it was prevention of gharar
relating to delivery of the exchanged article, in todays' complex financial
system and organized exchanges, it is prevention of speculation of kind
which is unIslamic and which is possible under excessive gharar involved
in forecasting highly volatile exchange rates. Such speculation is not
just a possibility, but a reality. The precise motive of an economic unit
entering into a future contract - speculation or hedging may not ascertainable
( regulators may monitor end use, but such regulation may not be very practical,
nor effective in a free market). Empirical evidence at a macro level, however,
indicates the former to be the dominant motive.

The second type of contracting with deferment of obligations of one
of the parties to a future date falls between the two extremes. While Sharia
scholars have divergent views about its permissibility, our analysis reveals
that there is no possibility of earning riba with this kind of contracting.
The requirement of spot settlement of obligations of atleast one party
imposes a natural curb on speculation, though the room for speculation
is greater than under the first form of contracting. The requirement amounts
to imposition of a hundred percent margin which, in all probability, would
drive away the uninformed speculator from the market. This should force
the speculator to be a little more sure of his expectations by being more
informed. When speculation is based on information it is not only permissible,
but desirable too. Bai salam would also enable the participants to manage
risk. At the same time, the requirement of settlement from one end would
dampen the tendency of many participants to seek a complete transfer of
perceived risk and encourage them to make a realistic assessment of the
actual risk. .

Notes & References

1. These diverse views are reflected in the papers presented at the Fourth
Fiqh Seminar organized by the Islamic Fiqh Academy, India in 1991 which
were subsequently published in Majalla Fiqh Islami, part 4 by the Academy.
The discussion on riba prohibition draws on these views.

6. Paper by Dr M N Siddiqui highlighting the issue was circulated among
all leading Fiqh scholars by the Islamic Fiqh Academy, India for their
views and was the main theme of deliberations during the session on Currency
Exchange at the Fourth Fiqh Seminar held in 1991.

7. It is contended by some that the above example may be modified to
show the possibility of riba with spot settlement too. "In a given moment
in time when the market rate of exchange between dollar and rupee is 1:20,
if an individual purchases $50 at the rate of 1:22 (settlement of his obligation
also on a spot basis), then it amounts to the seller of dollars exchanging
$50 with $55 on a spot basis (Since, he can obtain Rs 1100 now, exchange
them for $55 at spot rate of 1:20)" Thus, spot settlement can also be a
clear source of riba. Does this imply that spot settlement should be proscribed
too ? The fallacy in the above and earlier examples is that there is no
single contract but multiple contracts of exchange occurring at different
points in time (true even in the above case). Riba can be earned only when
the spot rate of 1:20 is fixed during the time interval between the transactions.
This assumption is, needless to say, unrealistic and if imposed artificially,
perhaps unIslamic.

8. Islam envisages a free market where prices are determined by forces
of demand and supply. There should be no interference in the price formation
process even by the regulators. While price control and fixation is generally
accepted as unIslamic, some scholars, such as, Ibn Taimiya do admit of
its permissibility. However, such permissibility is subject to the condition
that price fixation is intended to combat cases of market anomalies caused
by impairing the conditions of free competition. If market conditions are
normal, forces of demand and supply should be allowed a free play in determination
of prices.

9. Some Islamic scholars use the term forward to connote a salam sale.
However, we use this term in the conventional sense where the obligations
of both parties are deferred to a future date and hence, are similar to
futures in this sense. The latter however, are standardized contracts and
are traded on an organized Futures Exchange while the former are specific
to the requirements of the buyer and seller.

10. This is known as bai al inah which is considered forbidden by almost
all scholars with the exception of Imam Shafii. Followers of the same school,
such as Al Nawawi do not consider it Islamically permissible.

11. It should be noted that modern finance theories also distinguish
between conditions of risk and uncertainty and assert that rational decision
making is possible only under conditions of risk and not under conditions
of uncertainty. Conditions of risk refer to a situation where it is possible
with the help of available data to estimate all possible outcomes and their
corresponding probabilities, or develop the ex-ante probability distribution.
Under conditions of uncertainty, no such exercise is possible. The definition
of gharar, Real-life situations, of course, fall somewhere in the continuum
of risk and uncertainty.

12. The following traditions underscore the need to avoid contracts
involving uncertainty.

Ibn Abbas reported that when Allah's prophet (pbuh) came to Medina,
they were paying one and two years advance for fruits, so he said: "Those
who pay in advance for any thing must do so for a specified weight and
for a definite time".

It is reported on the authority of Ibn Umar that the Messenger of Allah
(pbuh) forbade the transaction called habal al-habala whereby a man bought
a she-camel which was to be the off-spring of a she-camel and which was
still in its mother's womb.

13. According to a tradition reported by Abu Huraira, Allah's Messenger
(pbuh) forbade a transaction determined by throwing stones, and the type
which involves some uncertainty.

The form of gambling most popular to Arabs was gambling by casting lots
by means of arrows, on the principle of lottery, for division of carcass
of slaughtered animals. The carcass was divided into unequal parts and
marked arrows were drawn from a bag. One received a large or small share
depending on the mark on the arrow drawn. Obviously it was a pure game
of chance.

14. The holy prophet is reported to have said " Do not sell what is
not with you"

Ibn Abbas reported that the prophet said: "He who buys foodstuff should
not sell it until he has taken possession of it." Ibn Abbas said: "I think
it applies to all other things as well".

15. The Futures Exchange performs an important function of providing
a guarantee for delivery by all parties to the contract. It serves as the
counterparty in the exchange for both, that is, as the buyer for the sale
and as the seller for the purchase.